Prologue – The Brave New World of Elastic Money
In the prologue we establish the main theme of the book, prepare the reader to question and challenge some readily adopted but false beliefs about money, and give an outline of the conclusions that the following analysis will arrive at.
We first define and delineate the problem. Money is essential for a functioning market economy. The question is whether money should be a commodity of limited and essentially inflexible supply, outside the control of states and banks, as it has been through most of human history, or whether it should be paper or electronic money (immaterial money) that the privileged money producers can create at almost no cost and thus without limit. The elasticity of supply is the key difference between the two systems. A return to commodity money would not mean that people could not use credit cards or electronic money transfers. These constitute innovations in payment technology by which ownership of money is transferred. They could be used under a gold standard, too. However, the overall supply of money would be essentially fixed.
The rest of the prologue projects the course of the subsequent analysis in broad strokes, leading to the conclusion that our present system is unstable and unsustainable, and that its endgame may be fast approaching.
PART ONE – THE BASICS OF MONEY
Chapter 1 – The Fundamentals of Money and Money Demand
We first explain the origin and purpose of money. Money is not a creation of the state but the result of the spontaneous interaction of the trading public. Without a good that functions as a medium of exchange, trading on markets would be severely limited. It was thus rational for traders to use certain goods as media of exchange. The most fungible good became money. Most societies throughout history have chosen the precious metals gold and silver to fulfil that role.
Money is unique. It is only demanded for its exchange value, not its use value, as is the case with all other goods and services. That is why, once a good is established as a medium of exchange, nothing can be gained from increasing its supply. The existing quantity can deliver all the benefits to society that a medium of exchange ever can deliver. But what if everybody in society wants to hold more money? The demand for money is always demand for readily spendable purchasing power, and this demand can be met by raising the exchange value of the monetary asset. If the public has a rising demand for money, the public will sell goods and services and try to accumulate larger money balances. As the overall supply of money is fixed, prices will tend to fall and the price of money, i.e. its purchasing power, will rise. This will naturally satisfy the demand for more spending power in the form of money. Nobody has demand for a certain number of gold coins or paper tickets. Demand for money is always demand for purchasing power and can always be met by adjusting the purchasing power of the monetary unit.
From this follows naturally that, if a person or an institution should manage to establish himself/herself or itself as society’s money producer and have his/her or its paper tickets accepted as money, this money producer can produce and place with the public practically any amount of money, regardless of the state of money demand. The extra and unwanted money will cause prices to rise, and at the lower purchasing power per unit of money the public will willingly hold the larger quantity of the monetary asset, simply to keep the same spending power in form of money as before. In sharp contrast to any other producer of goods and services, the money producer can disregard demand for his good and never run the risk of accumulating unsold inventory.
Chapter 2 – The Fundamentals of Fractional Reserve Banking
Most money today is produced by the banking sector which creates deposit money as part of its lending business in a process that is called fractional-reserve banking. When a depositor deposits money – whether commodity or paper money – with a bank, the bank does not simply safeguard the deposit but lends most of the money to other clients. These borrowers are, of course, likely to spend the money and the recipients of this money will deposit it again with their banks, and the process starts again. Thus, the banking system in aggregate creates multiple claims (bank deposits) on a limited supply of the original monetary commodity or the original supply of state paper money. The public considers these bank deposits to be money because the banks promise to redeem them instantly in cash or in transfers to other banks, which means these bank deposits also constitute readily spendable purchasing power. However, the banks hold, at any point in time, reserves for only a fraction of the deposits, thus the name ‘fractional-reserve banking’.
Our analysis shows how this practice evolved. It demonstrates that none of the participants in this process – the banker, the depositor and the borrower – take part in it in order to increase money holdings. Fractional-reserve banking is not practiced in response to the public’s demand for money, and the demand for money at any moment in time does not set any limitations to the extent that fractional-reserve banking can be conducted. As long as the public considers bank deposits a form of money, the banks are money producers and can thus create money regardless of demand. They are not even constrained by any specific independent loan demand. If the banks are willing to lower their reserve ratios, they can produce deposit money and therefore increase the volume of credit, which should lead to lower interest rates on the market. Under normal circumstances, the demand for loans will rise if interest rates fall. The only constraining factor for the bank’s money creation is the limited supply of reserves and the risk of a bunk run.
Fractional-reserve banking is profitable but risky for the banks, and it also has grave consequences for the overall economy, as economists began to suspect long ago and as has since been convincingly argued by the Austrian economists Ludwig von Mises and F. A. Hayek. The long-term consequences of expanding credit are very different depending on whether credit is based on true voluntary saving or based on money creation. In the case of the former you get sustainable growth, in the case of the latter, you get boom and bust.
Such business cycles occurred already under gold standard regimes but were still confined because the limited and inelastic supply of gold reserves restricted the activities of fractional-reserve banks. This changed in the course of the twentieth century as governments increasingly encouraged fractional-reserve banking, most notably by assigning a lender-of-last resort function to a government agency, the central bank. Even the central bank could not create gold when banks ran out of reserves, so the next step was to replace commodity money with unlimited state paper money under the control of the central bank. When the credit boom now turns into a bust, the central bank can create reserve money at will, and extend the boom further. But if the extension of credit based on the printing of money has disruptive consequences in the long run, and if these are absent if credit is funded with true saving, the inevitable disturbances will eventually be larger in a paper money system than in a commodity money system.
PART TWO – THE EFFECTS OF MONEY INJECTIONS
Chapter 3 – Money Injections Without Credit Markets
Now that we established that in our present paper money system money creation does not occur in response to the public’s demand for money but to the extent that the central bank allows, supports and actively encourages the production of money and credit by fractional-reserve banks, which means that money creation is a discretionary act of politics, not a market phenomenon, we turn to an analysis of the effects of money injections. In order to work out all the consequences we construct a number of models, starting with very simple ones and, step by step, progressing to more realistic scenarios. In this chapter we assume that no credit market exists. We look first at even, instant and transparent money injections, in which everybody is affected in the same way by the new money, a situation that would be impossible in the real world. Only in this most unrealistic scenario does a money injection impact nominal prices alone and has no effect on the ‘real’ economy. Only in this scenario is the change in the price level proportionate to the money injection.
In all other scenarios, and in particular if the injection is uneven and the new money reaches some people before it reaches others, the money injection must raise prices but must also cause changes in relative prices and in resource allocation. Additional economic transactions now unfold that would not take place if new money had not been created. The GDP statistics will now show a rise in economic activity. However, we show conclusively that this effect is always transitory and that it does not enhance overall wealth. Instead, the additional economic activity is purely adjustment activity by which the market adapts to the discretionary injection of additional money. More specifically, resources are shifted from the late recipients of money to the earlier recipients of money. Money injections always shift control over resources and change the distribution of wealth and income. They create winners and losers. But, importantly, money injections can never lastingly improve the productivity of the economy overall or create wealth. This outcome is not surprising if we consider that money is purely a medium of exchange, as elaborated in chapter one.
Chapter 4 – Money Injections via Credit Markets
In order to explain the full range of the effects of money injections via credit markets, we have to establish a couple of key economic concepts first, such as saving, investment and interest rates. We show that the additional money increases the volume of loans available on financial markets and causes interest rates to drop. This encourages extra borrowing and additional investment by entrepreneurs, and leads to an extension of the capital structure. An investment-led boom is the consequence. This would also be the result if voluntary saving had increased. Then, too, additional funds would have been available on credit markets, depressing rates and stimulating borrowing and investing. While the immediate consequences are identical, the long run effects are very different. If investment is based on money printing and not on saving, nobody freed up resources from their employment close to consumption and allowed them to be redirected towards investment. Consumers still demand these resources to be used for consumption purposes. Without the resources that only true saving can make available, the additional investment activity will ultimately prove unsustainable. The mismatch between saving and investment that is the result of a money-induced credit boom must turn the initial boom into a bust. A recession becomes unavoidable because the activity that was initiated in the false expansion is not supported by the public’s true propensity to save and must be discontinued.
The only way to avoid such painful recessions is to avoid the preceding artificial, because money-induced, booms. Money should be less elastic, not more elastic. As we have seen, the opposite has occurred throughout the twentieth century. Everywhere inelastic commodity money has been replaced with fully elastic state fiat money under the control of central banks that fulfil a lender-of-last resort function to the fractional-reserve banks. Credit booms can now be extended much further, meaning the underlying dislocations get substantially bigger. As the inevitable corrections will now be much more severe, policy makers will try to postpone them ad infinitum with ever more aggressive money injections. The endgame will be inflation and the collapse of the paper money system.
PART THREE – FALLACIES ABOUT THE PRICE LEVEL AND PRICE LEVEL STABILISATION
Chapter 5 – Common Misconceptions Regarding the Price Level
In this chapter we expose some of the common fallacies in respect to the price level and the policy of price level stabilisation. We show that the disruptive effects of an expanding money supply occur even if the money injections do not lift the price index meaningfully and standard inflation measures remain unchanged. This could be the case if, over any given period, a coincidental rise in the public’s demand for money exerts downward pressure on prices and thus cancels out some of the price lifting effects from the injection of new money. We show that even in this scenario, the money injection causes the misallocations of capital and the ensuing economic instability described in the previous chapter. A stable price index is frequently a misleading indicator of general monetary and economic stability.
Furthermore, we show that, historically, commodity money has been remarkably stable in terms of its purchasing power while all paper money systems have experienced inflation and monetary instability, leading either to their breakdown or a return to commodity money. Inflation and corrective deflations are entirely phenomena of paper money systems. Economically destabilising swings in money’s purchasing power were largely unknown to commodity money societies. We show via a conceptual analysis why commodity money is inherently stable. We also show that, while it is true that a system of inelastic money makes ongoing secular deflation likely, such a steady and moderate decline in prices does not constitute a problem but, in fact, has many advantages.
Chapter 6 – The Policy of Stabilisation
In this chapter, we show why no system of paper money can provide a stability of the monetary unit’s purchasing power that is superior to that of commodity money, even if this were the only goal of monetary policy. Moreover, the present policy of generating continuous moderate inflation means that money injections are ongoing, which in itself must generate instability and economic volatility.
PART FOUR – HISTORY OF PAPER MONEY: A LEGACY OF FAILURE
Chapter 7 – A Brief History of Paper Money
In chronological order, we list the major experiments with complete paper money systems, starting with the Chinese dynasties of the twelfth to fifteenth centuries, progressing to the paper money systems in Massachusetts in the late seventeenth century, the ones in France in the early eighteenth century and again towards the end of the eighteenth century, after the French Revolution, and the American paper money system of the American Revolution. We also take a look at the various paper money episodes that occurred during the long history of the pound and the dollar, as these two currencies were also taken intermittently off gold and off silver, for example during the Napoleonic wars, and the dollar again around the time of the American ‘Civil War’. We show that the twentieth century was the century ideologically most hostile to commodity money and limited government, and therefore also the century with by far the most currency disasters.
Some consistent themes emerge from the historical record. Commodity money was never replaced with paper money in order to provide the economy with a more stable medium of exchange. In fact, paper money was never introduced on private initiative but invariably by state authority with the undeniable and often openly stated goal to fund state spending, more often than not, war. After some time, the paper money system always produced inflation and progressively rising inflation at that. All paper money systems in history ended in failure. Either the monetary authorities abandoned paper money and returned to commodity money before the monetary system collapsed, or ever more paper money was produced and the system disintegrated in hyperinflation and economic and societal chaos.
PART FIVE – BEYOND THE CYCLE: PAPER MONEY COLLAPSE
Chapter 8 – The Beneficiaries of the Paper Money System
In this final part of the book we focus on the present paper money system and analyse the most likely course of its demise. That this paper money system, too, is unsustainable and must ultimately collapse under the weight of its own inconsistencies should be beyond doubt at this stage of the investigation. In order to forecast as well as possible the precise path to the system’s disintegration, it is important to first understand the interested parties that benefit from this system and the widely accepted belief system that has so far guaranteed the support from the public.
How the banks and the wider financial industry benefit is not difficult to see. In a complete paper money system bank reserves are fully elastic, and, combined with the central bank’s role as a lender-of-last resort, this provides an essential government backstop to the banks when engaging in the risky but very profitable practice of fractional-reserve banking. In a paper money system banks can augment their credit business through the constant issuance of predominantly uncovered claims to state paper money (bank deposits) to a degree that would be entirely unfeasible in a free banking market with inflexible commodity money. Banks thus participate in the state’s monopoly of fiat money creation. The wider financial industry benefits as it receives newly injected money early in the distribution process before it has lost some of its purchasing power.
The state also benefits from its ownership of the printing press. Not having to obtain market income but enjoying the privilege of legally expropriating market income earners in its territory by taxing them already gives the state an exalted position among borrowers and generally allows it to crowd out private debtors on financial markets. This status is further enhanced when the state acquires the monopoly control over the local paper money. For as long as the paper money system holds, the state can run larger deficits and obtain greater control over society’s real resources. We also show how our financial infrastructure allows the state to place substantial amounts of government bonds with its own central bank and the nominally private banks, and how this system allows the state to grow in good and bad economic times. Paper money is not the creation of the market but of politics. It is a tool of state power, and under a paper money system state power will necessarily expand.
We also explain how this system has given rise to the new class of professional economists by providing them with positions of influence and gainful employment as central bankers, policy advisors, policy analysts and market commentators that would certainly be unavailable in a free market with hard money, no central bank bureaucracy and a less bloated financial sector. In turn, economists have become the intellectual guardians of the paper money system. Most professional economists today stress those parts of modern mainstream macroeconomics that seem to lend support to state-controlled flexible paper money and they have become indispensible intellectual defenders of a system that is essentially anti-market and anti-private property, that benefits the money-producers and those close to them, and that must create progressively larger economic imbalances over time.
Chapter 9 – The Intellectual Superstructure of the Present System
In this chapter we analyse the specific belief system that today guides the actions of policy makers and that shapes the views of most economists. We bring out its key features in sharp relief by first establishing the alternative and traditional view of the market economy as a tool for the spontaneous co-ordination of individual plans. Only markets allow an extensive division of labour that enhances the material wellbeing of everybody who participates in it. The market is a framework for human co-operation that serves its participants but lacks an overarching goal or single unified purpose. For it to function, price formation simply has to be entirely uninhibited. Importantly, this includes interest rates, by which investment activity is synchronised with the propensity of the public to save.
Intellectual trends of the twentieth century in particular, have replaced this time-honoured perspective with a different view of the economy and the market: Today, the economy is seen, not as a framework for spontaneous co-operation of otherwise unconnected individuals, but as a wealth-enhancing machine that may at times operate below its potential. If that is the case, policy, guided by the expert opinion of professional economists, has to manipulate the machine in order to deliver ‘better’ results. In the world of social science, the rise of macroeconomics has shifted the focus of economic debate to a set of national account statistics and has nurtured the erroneous belief that it is these macro-aggregates that interact with one another in the economy, and that specific values of these aggregates can be equated with overall economic health and general material wellbeing. Thus, policy has taken it upon itself to manipulate prices, such as interest rates, in a certain direction to deliver ‘better’ economic outcomes. We show that such interventions, even if they are advertised as ‘stimulus’ and made to appear as delivering universal advantage, can never benefit everybody but will always benefit some at the expense of others. In the process, they must inevitably obstruct the overall co-ordination of individual plans that is the true benefit of a market economy.
We show that this approach to economic phenomena has strong appeal to politicians. We also show that most modern schools of economics have adopted this approach. Even if they appear, superficially, to be antagonistic in their views, such as Keynesianism and Monetarism usually do, they often share the same methodological foundation and are thus bound to make the same errors. Consequently, as the paper money system shows increasing signs of disintegration, these are not contributed to the elasticity of money and the dislocations necessarily produced by it, but are instead simply seen as a sign of a weak economy and a lack of ‘aggregate demand’, which is believed to require additional policy intervention, usually in the form of more money creation. We show how this progressively unbalances the economy further and makes the underlying dislocations bigger. As the market distortions become ever more palpable, the mainstream economist has to explain them. We look at one of the alternative theories for explaining money-produced asset bubbles and excessive levels of debt, namely the popular ‘savings glut’ theory, and show that it does not stand up to critical examination.
Chapter 10 – Paper Money’s Endgame
Only two endgames have occurred in the history of paper money systems and only these two are theoretically possible. First, the printing of money and the artificial lowering of interest rates are terminated voluntarily. The system is returned to hard money of essentially inflexible supply, such as a proper gold standard, in which investment is based on saving and the two are co-ordinated through uninhibited market prices. The unrestricted and undoubtedly painful liquidation of accumulated misallocations of capital is allowed to proceed, bringing asset prices and capital structures again in line with the pool of available savings. Second, the unsustainability of present structures is not acknowledged. Instead, ever more aggressive money injections and increasingly other interventionist policies are used to postpone the inevitable correction ever further and thus make the underlying distortions ever bigger. As ever more money is printed to simply sustain the mirage of solvency of sovereign states and banks, the public loses faith in state fiat money and tries to disengage from it. The system ends in hyperinflation and economic collapse. Then, the misallocations will finally be liquidated but now in form of a total currency collapse with considerable damage to the entire economy and, in fact, the social fabric.
We explain why the second outcome is considerably more likely today. We show that the dislocations that have accumulated in the present system of elastic money are most certainly larger than they were at the start of the Great Depression in the 1930s. With the policy establishment beholden to the standard macro-paradigm and unlikely to give up the tool of elastic money or their belief in the manageability of the economy, we will witness the nationalisation of money and credit. As overleveraged private institutions will find it difficult to expand their balance sheets further, lending and borrowing will increasingly be conducted by state entities, such as the central bank and state-owned financial institutions. States will also increasingly use the printing press to fund their expenditures. Large-scale debt monetisation will occur under the cover of policy ‘stimulus’ (‘quantitative easing’), a process that is already well advanced. This must ultimately lead to an inflationary meltdown.
While it appears exceedingly unlikely that a more benign outcome is still possible, the only hope is that, as the catastrophe unfolds, the market will re-monetise the precious metals, in particular gold, and when state paper money collapses once again, an entirely private monetary system will arise, based on privately-run gold depots and privately-run international payment system. This would provide a stable, de-politicised system of hard-money for an increasingly international division of labour to replace the current patchwork of highly unstable local state paper monies.